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Thursday, May 9, 2013

Why IRR is not used in decision-making

IRR calculations are inaccurate due to external inflation
IRR is a financial metric meaning  Internal Rate of Return

By Richard Craft

When it comes to evaluating investments, there are many things to consider. Risk, probability of success, capital funding, market conditions and the current state of the economy are all things potential investors need to ruminate on. In fact, finance careers such as financial planning and financial analysis exist in large part due to the complexities related to drawing conclusions about investments. Chartered Financial Analysts, or CFAs, analyze and research equity investments for individuals or firms while Certified Financial Planners, or CFPs, evaluate what investments meet their clients’ needs. 

In the process of predicting an investment’s future performance and longevity, the internal rate of return, or IRR, is a value that often receives much consideration. The internal rate of return of an investment is a value not affected by outside influences that are used to compare investments to one another. IRR is also known as an effective interest rate or an economic rate of return. To many novice analysts, IRR is a logical place to focus one’s attention. (After all, this value is the return a particular fund or security can allegedly produce.) However, as any CFA or CFP can tell you, just looking at a particular investment’s IRR is a critical mistake. 

Why investors can’t depend on an IRR

IRR is used to calculate the estimated yield of a particular investment based solely on internal factors. In general, an IRR that exceeds the capital invested is considered at worst an average investment. The calculations for an internal rate of return are very complex, but they involve looking at factors like cash flow, the length of the investment, and the project the investment is funding. While IRR is certainly an important part of investment analysis, neglecting to look at the outside factors that are not taken into account when calculating an internal rate of return is a critical error. 

Downfalls of IRR calculations

One of the fundamental downfalls of internal rate of return calculations from an overarching analytical perspective is its very nature. An internal value has some inherit worth in its intended purpose, but excluding external factors is very misleading. IRR does not take anything peripheral into consideration: from estimated risk to company liability, to more general economic conditions, like the stability of market trends and the current health of any specific markets investments may be partially invested in. These so-called “outside factors” need as much consideration as IRR. If an investment has a high IRR, but the country or state in which the investment is going to take place has an unstable economy or weak market performance, it is unlikely a predicted rate of return will be achieved. 

In the case of long-term investments, inflation often has a strong impact on a security’s worth or a fund’s yields. Inflation rates over the last ten years have spanned from around one percent to slightly over four percent. If rates rise for several years consistently, the true yield could deviate quite significantly from the IRR a fund calculated at its inception. Additionally, investments in an organized fund or through an investment advisor generally have fees attached. Keep these additional fees, as well as any transaction fees, in mind when considering how much your share in an investment might be worth in the future.

No analyst will argue the point that IRR is unimportant, but few will insist that it is the only factor to consider. Regardless of what sort of investment you are interested in, be sure to take all relevant influences into consideration. If you’re unsure about any kind of investment analysis, consider discussing your portfolio interests with a professional.

About the author: This article was contributed by Richard Craft, an aspiring financial analyst who is looking forward to sharing his knowledge on the web. He writes this on behalf of KEL Credit Repair, your number one choice when you need credit repair help to start getting back on the right financial path.

Image license: Shutter-stock, royalty free

1 comment:

  1. It is really tough to choose between CPA/CFA, but one has to take a timely decision to avoid confusion.